Question

The company estimates that it can issue debt at a rate of rd = 9%, and its tax rate is 40%. It can issue preferred stock that pays a constant dividend of $6 per year at $57 per share. Also, its common stock currently sells for $39 per share; the next expected dividend, D1, is $4.75; and the dividend is expected to grow at a constant rate of 4% per year. The target capital structure consists of 75% common stock, 15% debt, and 10% preferred stock. What is the cost of each of the capital components? Round your answers to two decimal places. Do not round your intermediate calculations. Cost of debt % Cost of preferred stock % Cost of retained earnings % What is Adamson's WACC? Round your answer to two decimal places. Do not round your intermediate calculations. % Only projects with expected returns that exceed WACC will be accepted. Which projects should Adamson accept? Project 1 Project 2 Project 3 Project 4

Answer 1

Answer:

a)

Cost of debt (after tax) = 5.4%

Cost of preferred stock ($r_p$)  = 10.53%

Cost of common stock ($r_e$) = 16.18%

b)

WACC = 14%

c)

project 1 and project 2

Explanation:

Given that:

Debt rate ($r_d$) = 9% = 0.09

Tax rate (T) = 40% = 0.4

Dividend per share ($D_p$) = $6

Price per share ($P_p$) = $57

Common stock price ($P_0$)= $39

Expected dividend ($D_1$) = $4.75

Growth rate (g) = 4% = 0.04

The target capital structure consists of 75% common stock ($w_e$), 15% debt ($w_d$), and 10% preferred stock  ($w_p$)

a)

Cost of debt (after tax) =`$r_d(1-T)= 0.09(1-0.4)=0.09*0.6=0.054$

Cost of debt (after tax) = 5.4%

Cost of preferred stock ($r_p$) = $\frac{D_p}{P_P}=\frac{6}{57}=0.1053$ = 10.53%

$r_p$ = 10.53%

Cost of common stock ($r_e$) = $\frac{D_1}{P_0} +g=\frac{4.75}{39} +0.04=0.1618$

$r_e$ = 16.18%

b)

$WACC=w_dr_d(1-T)+w_er_e+w_pr_p\\WACC=0.15*0.09(1-0.4)+0.75*0.1618+0.1*0.1053=0.14$

WACC = 14%

c) Only projects with expected returns that exceed WACC will be accepted. Therefore only project 1 and project 2 would be accepted